When Debt Goes Wrong
This week, we’ll be discussing when you might have issues making your required payments or living up to requirements that you previously agreed to with your lender. As we’ve pointed out since our first issue, debt is a serious commitment for any company. Management should carefully evaluate beforehand. However, this is a two-sided relationship. Let's not forget that the lender is signing up for some risk as well.
Lenders Know The Risk
Debt providers do their diligence on your company and make a committed decision to partner with you. If you’ve ever met a lender or taken debt before, you know they need a lot of questions answered before deciding to give you money. Speaking as a former lender, we can be a reasonably nervous bunch.
While VCs only need to have one deal to be a massive success, lenders need the opposite. A lender’s goal is to lose as little money as possible, while still making some money. A lender needs more than a good feeling or a gut reaction to provide you with cash.
Maybe something unexpected has changed the expectations that you set with them initially (*cough* COVID *cough*). Don't worry about things changing. There’s a universal truth that every startup financier knows – Startup projections are always wrong (to some degree). We always hope you’ve wildly underestimated how fast you’ll grow, but we know it's more likely that you don't hit your numbers.
Any experienced lender expects to have conversations about business performance because every company struggles in some way. The key is to set reasonable expectations to make the future dialogue as easy as possible.
We Hit A Bump, Now What?
If you’re facing a situation that could impact your debt obligations, communicate it early. Don't wait or hide it. Ideally, notify your financing partner of any possible issues well before you miss any requirements. Not only does it leave all options available, it allows everyone to discuss the available options calmly.
Most lenders want to find a way to accommodate bumps in the road rather than penalize you for them. But before they can make any changes to the deal, they’ll want to make sure you’ve evaluated all other options. Lenders will want to discuss the following items:
What changes can management make?
The goal is to prevent the company from finding itself in a similar situation again. It could mean you evaluate small changes, like spending less on variable expenses, or more drastic measures, like layoffs.
How can your investors help out?
If you need more capital but already struggle to maintain your current debt amount, asking for more debt will undoubtedly make it worse. If your investors are supportive and capable of putting more money in, this may be the best solution for your current debt issue.
If none of these options will solve your problems, it's time to work with your lender. Depending on the issues you face as a business, it may require collaboration and creativity to find the right solution.
It's essential to understand that any changes a lender makes to the original agreement will likely start a path to ending the relationship. If they work with you to accommodate the issues you’re facing and you ultimately pay them back, don't be surprised if they don't want to work with you again.
Bad Situations are Bad for Everyone
There are worst-case scenarios where the lender uses their rights to take your assets, or even shut down your company, to get their money back. But it’s rare that they’d do this without your or your investors' involvement. This “worst-case” is typically the result of them not having enough time to respond to the changing situation or having exhausted all other options.
Worst-case scenarios are bad for the entrepreneurs and the lender. It creates a lot more work and cost for the lender to try to get their money back. Not to mention the reputation damage that could stop them from working with a startup ever again. Of course, this all assumes that you have done your diligence on who could be a great partner long before the issues arise.
Communicate with your financing partner early and often when you expect trouble in the debt relationship. And don't assume they won't be willing to work with you through the ups and downs. It's a lie that only equity investors will treat you well when your company sees hard times. I know of far more instances where founders were bitten by their equity investors than companies who were taken over by their lenders.
Start your Thursday off right — subscribe to INTRO to Finance to receive a new issue every week.
